EU Integration Dead In The Water

BMI View : The collapse of historic Association Agreement talks between the EU and Ukraine points towards a path of long-term economic and political stagnation for Ukraine. While closer ties with Russia may be positive for near-term economic stability if a deal on cheaper gas can be struck, the odds of positive economic and political reform gaining momentum over the next few years will decline significantly.

Association Agreement talks between Ukraine and the EU collapsed abruptly on November 21, with Ukraine announcing it intends to pursue closer ties with Russia, despite its repeated insistence over the past few months that a deal with the EU was on the cards. In response to Ukraine's EU ambitions, Russia has repeatedly made threats of an all out trade war, which would likely have pushed Ukraine's already fragile economy into a full-blown economic crisis.

However, the EU has been relatively reluctant to put any money on the table - and we believe that this is the single most important factor underpinning the suspension of talks. It is increasingly apparent that despite recent diplomatic efforts, Ukraine is just not that valuable to the EU. While Ukraine's sharp diplomatic U-turn could be a final hard-ball tactic to push the EU into offering substantially more financing, momentum is fading rapidly, and EU diplomats appear to have given up hopes that the agreement will be signed at the Vilnius summit. If Ukraine does not sign the agreement in late November, the window of opportunity is unlikely to reappear for several years.

Short-Term Gain, Long-Term Pain
Ukraine - 5 Year Sovereign CDS, basis points

BMI View : The collapse of historic Association Agreement talks between the EU and Ukraine points towards a path of long-term economic and political stagnation for Ukraine. While closer ties with Russia may be positive for near-term economic stability if a deal on cheaper gas can be struck, the odds of positive economic and political reform gaining momentum over the next few years will decline significantly.

Association Agreement talks between Ukraine and the EU collapsed abruptly on November 21, with Ukraine announcing it intends to pursue closer ties with Russia, despite its repeated insistence over the past few months that a deal with the EU was on the cards. In response to Ukraine's EU ambitions, Russia has repeatedly made threats of an all out trade war, which would likely have pushed Ukraine's already fragile economy into a full-blown economic crisis.

Short-Term Gain, Long-Term Pain
Ukraine - 5 Year Sovereign CDS, basis points

However, the EU has been relatively reluctant to put any money on the table - and we believe that this is the single most important factor underpinning the suspension of talks. It is increasingly apparent that despite recent diplomatic efforts, Ukraine is just not that valuable to the EU. While Ukraine's sharp diplomatic U-turn could be a final hard-ball tactic to push the EU into offering substantially more financing, momentum is fading rapidly, and EU diplomats appear to have given up hopes that the agreement will be signed at the Vilnius summit. If Ukraine does not sign the agreement in late November, the window of opportunity is unlikely to reappear for several years.

Economic Implications: Eschewing the EU's offer of Association Agreement in favour of closer relations with Russia is likely to mean a cheaper deal on gas, which would substantially help to reduce Ukraine's external imbalances as well as reducing the budget deficit due to lower fiscal transfers to state-owned Naftogaz. This outcome would therefore be positive in the short term, reducing the risk of a credit event. If a deal for cheaper gas is struck, hryvnia devaluation risks will decline substantially due to lower external account pressures, and we would adjust our FX forecasts accordingly.

Over the long term, this outcome is extremely negative for economic growth prospects. Cheaper gas provides little incentive for Ukraine to adjust its outdated economic model, underpinned by an inefficient metallurgical sector, while absence of the EU as a policy anchor is likely to see Ukraine's business environment stagnate, restraining external investment.

Political Implications: The Association Agreement was the primary leverage the EU had over Ukraine. While the EU could theoretically apply economic and political sanctions on Ukraine (as it has done with Belarus), this is unlikely to happen at any point in the near future. Former Prime Minister Yulia Tymoshenko is therefore likely to remain imprisoned, leaving UDAR leader Vitali Klitschko as Yanukovych's main challenger in the 2015 Presidential elections. Over the short term, mass demonstrations led by opposition parties are likely. Political risk is likely to increase over the coming quarters as Yanukovych attempts to consolidate his power further.

Asset Class Implications: A deal for cheaper gas imports could help to ease pressures on fiscal and external accounts, which would be positive for bonds and hryvnia stability. However, no such deal has been announced yet, and Ukraine remains at high risk of default. Ukraine's PFTS stock exchange will probably continue its terminal decline, and Ukrainian exporters listed aboard may suffer. Companies such as poultry producer MHP, which recently begun to export to the EU may be negatively impacted.

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This article is tagged to:
Sector: Country Risk
Geography: Ukraine, Russia
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